Fund Manager Review December 2023

“All you had to do was stay”

The title of this song by Taylor Swift nicely describes the market action in December. After the strong gains over the previous month, one could have expected the markets to take a breather, but the positive momentum continued well into year end. As the federal reserve signaled that they should be done raising interest rates, major stock markets performed strongly, and interest rates continued to fall. It feels like there is a lot of good news (i.e. rate cuts) priced now, but given the pain we felt in late October, we will not complain about this year‘s extended Santa Rally.

The Tareno Global Water Solutions Fund posted a perfor­mance of +6.21% (W‑Euro Tranche) and ended the year 2023 at +13.14%

A look in the rear-view mirror

Having covered the water sector since 2007, we’ve observed notable shifts in the industry landscape. One persi­stent element, however, is the marked disso­nance between the thematic enthu­siasm surroun­ding water and the pragmatic reali­ties of an industry comprised mostly of seasoned, cyclical enter­prises. Front­line personnel within these compa­nies often appear surpri­singly discon­nected from the substan­tial exagge­ra­tions and inflated assess­ments of their profes­sion propa­gated by investors. In short, even in the invest­ment universe of water, one can be mistaken in their assess­ment. We are not immune to that either.

Now, where have we been wrong in 2023? We bet on an outper­for­mance of Japanese compa­nies. They trade at very attrac­tive levels compared to their US peers and in the case of the compa­nies we choose are supported by strong tailwinds. Kurita Water, just to name one company, is a key supplier of ultra-pure water treat­ment systems, that are essen­tial to the manufac­tu­ring of Semicon­duc­tors. The ongoing trend of nearsho­ring capacity provides them a solid runway to increase revenues. While this could be seen in their results, the extent of the Yen’s weakness caught us off guard (we do not hedge curren­cies). The most signi­fi­cant negative impact on perfor­mance came from the agriculture/irrigation segment. We undere­sti­mated the impact of rising interest rates in combi­na­tion with falling soft commo­dity prices on the demand for irriga­tion systems. We have signi­fi­cantly reduced our exposure, but unfort­u­n­a­tely, we were a bit too late.

Now, for the good ones: 2023 was a brutal year for water utili­ties, especi­ally in the US. They typically trade high-beta to interest rates and see their prices falling, as yields go up. We were right to under­weight US names and focus on more compel­ling stories like Sabesp in Brazil, or Veolia, ACEA and EVN AG (one of our best performing names at +73%) out of Europe. We were right to be patient with construc­tion related names, even if the sector came under pressure during the 2nd half of the year. Construc­tion has been the stron­gest contri­butor to returns in 2023 with names like Wiener­berger, Pentair, Ferguson, and Mueller Industries in top positions regar­ding contri­bu­tion. If funda­men­tals are right, then “all you have to do is stay”. Mueller Industries is emble­matic of this Song. They trade at 8.5 P/E, they have about USD 9.- per share in cash on their balance sheet, but nevert­heless saw their stock falling 23% from July till October, only to mark a new all-time high in December.

Outlook water market 2024

The book is closed for another year and 2024 is upon us. Finan­cial markets will always carry a certain degree of uncer­tainty, but the picture heading into 2024 appears much clearer than this time last year. Infla­tion is cooling and interest rates are expected to fall. There is a chance that the US will avoid falling into a prolonged reces­sion and while geopo­li­tics are clearly a risk, I’m optimi­stic for the market in general. The small and midcap universe has room to run, which is a clear positive, since this is the space where water stocks play. Regula­tion will be an important driver this year. The EPA has ignited a wave of efforts, both in the US and inter­na­tio­nally, to combat the widespread conta­mi­na­tion of water supplies with PFAS substances. This will create a favorable environ­ment for suppliers of activated carbon filters and water treat­ment systems. As climate change conti­nues to take its toll, there will be invest­ments in water infras­truc­ture to reduce leakage, prevent sewer overflow (UK) and manage storm­water. Our trip to Aquatech in Amsterdam confirmed that A.I. is on the verge of making its way into the industry.

Another topic that is gathe­ring traction is water reuse. In December, California reached a signi­fi­cant milestone by appro­ving its initial standards for trans­forming sewage into potable water sources for residen­tial and commer­cial use. This marks a depar­ture from the current practice of mixing recycled water into aquifers or utili­zing it for non-drinking purposes like irriga­tion. Waste­water is produced during a drought and having that source available can be critical. We might not be there yet, but water reuse requires a lot of invest­ment in water techno­logy.

Looking at sectors, 2024 might stage a comeback for US utili­ties, especi­ally if interest rates start to ease further. We are currently looking at names like Essen­tial Utili­ties and American Water­works to build up positions. Finally, Emerging Markets might offer a good entry point.

We believe there is a range of exciting milestones ahead for water compa­nies in 2024 and beyond.

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